Uncertainty and monetary policy rules in the United States

“Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape” (Greenspan 2003).

Uncertainty is a central issue in monetary policy, as the quote from Alan Greenspan above illustrates. Empirical models, however, rarely take account of this, effectively assuming that policymakers ignore uncertainty. The evident focus of policymakers on uncertainty suggests that this assumption is invalid and therefore that empirical models of monetary policy must account for uncertainty. This article considers the effects of uncertainty about the true state of the economy on monetary policy, estimating a monetary policy rule that allows for this.

Our empirical model combines elements of Svensson’s (1997) model of inflation forecast targeting with models drawn from the theoretical literature on optimal monetary policy when there is uncertainty about the true state of the economy, most prominently Svensson and Woodford (2003, 2004) and Swanson (2004). In existing models of monetary policy under certainty, monetary policy affects inflation and the output gap directly, so it is optimal for policymakers to use these variables in forming monetary policy. This is the basis for the Taylor rule (Taylor 1993) model of monetary policy and its subsequent refinements (e.g., Woodford 2003).

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International Currency Exchange Rates & Monetary Policy Considerations

International currency exchange rates are a mechanism for determining the relative value of one currency against another. Rates are set by the forces of supply and demand. Market participants negotiate an agreed value at which the exchange takes place. There is no one centralized market place for exchange rates but the majority of transactions occur on the Interbank market between the participants who negotiate the agreed price. Exchange rates are essential for maintaining a workable framework for all matters of international trade and commerce. This article will examine the role of exchange rates and how they can influence economic and planning decisions.

Currency exchange rates affect foreign trade. International exchange rates allow countries to determine the relative cost of goods for sale. When one countries exchange rate rises or falls against another, it can create a shift in the way trade and commerce is conducted. Manufacturers and exporters price the cost of their goods in their base unit of currency. If the exchange rate appreciates to a considerable extent then it makes the cost of goods more expensive to the foreign purchaser. This can result in a reallocation of resources as demand for the goods shift to a comparatively cheaper supplier.

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UK Monetary Policy: Does it Work

The main instrument of UK monetary policy is the use of interest rates, set by the MPC. The theory is that interest rates are very effective in controlling inflationary pressures. The relative success of meeting the government’s inflation target in the past 7 years suggests that this proves the effectiveness of monetary policy.

In brief raising interest rates helps to reduce Aggregate demand in the economy. When interest rates are raised several things are affected. Firstly those with mortgages have higher monthly payments, this reduces their disposable income and reduces their spending. Secondly there is an increased incentive to save money rather than spend. Thirdly those who have other forms of borrowing will be hit with increased interest repayments, it will also discourage people from buying on credit. Therefore in principal raising interest rates will reduce demand and prevent the economy from overheating. This enables inflationary pressures to be subdued.

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